Bush Administration Tax Policy

Effects on Long-Term Growth

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I. Introduction

This article is the fourth in a series that evaluates tax policy in the Bush administration and focuses on how making the 2001 and 2003 tax cuts permanent would affect long-term economic performance.1

Tax policy can change the size of the future economy in either of two ways: by affecting the underlying growth rate or by creating a one-time permanent shift in the level of economic activity (without affecting the underlying growth rate). In this article, both effects will be considered to imply an effect of taxes on long-term economic growth. The tax cuts' effects on long-term economic performance, however, is distinct from their ability to stimulate the economy in the short run. In the short run, in an economy operating with excess capacity, increases in aggregate demand can raise output and income even without increasing the capital stock. In the long run, however, economic growth reflects increases in the capacity to generate income through technological change, and the increased supply and better allocation of labor and capital. A subsequent article in this series will address the short-term, stimulative effect of the tax cuts.

The net effect of the tax cuts on growth is theoretically uncertain. The tax cuts certainly offer the potential to raise economic growth by improving incentives to work, save, and invest. But the tax cuts also create income effects that reduce the need to engage in productive economic activity, and they subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity. Also, making the tax cuts permanent would raise the deficit over the medium term, in the absence of any offsetting revenue increases or spending cuts. The increase in the deficit will reduce national savingand with it, the capital stock owned by Americans and future national income.

Several studies have quantified the effects noted above in different ways and used different models, yet all have come to the same conclusion: Making the tax cuts permanent is likely to reduce, not increase, national income in the long term unless the reduction in revenues is matched by an equal reduction in government consumption. And even in that case, a positive impact on longterm growth occurs only if the spending cuts occur contemporaneously, which has decidedly not occurred, or if models with implausible features (like short-term Ricardian equivalence) are employed.